For years U.S. corporations have been moving operations to offshore tax havens and using other accounting workarounds to lower their federal income taxes or avoid paying them all together. Previously there was a large loophole in the U.S. tax law that enabled corporations to avoid paying all taxes on foreign profits until they were brought home.
This strategy was known as “deferral” and it provided huge incentives for overseas U.S. businesses to keep their profits offshore as long as possible. By funneling profits through shell companies, corporations were able to essentially never bring their profits back to the states and in return never have to pay a dime of federal income taxes.
On December 22, 2017 The Tax Cuts and Jobs Act (TCJA) was signed into law and has major changes to how US businesses are taxed. The new law no longer contains the deferral loophole and imposes a one-time transition tax on the accumulated profits earned during the taxable years they business operated as a deferred foreign income corporation (DFIC).
Under the TCJA transition tax, DFIC businesses will be taxed at a rate of 15.5 percent for earnings held in cash or 8 percent for earnings held in illiquid assets. The law allows for US shareholders to elect to pay their owed transition tax over a maximum period of 8 years.
For individual shareholders that hold their interests in DFICs through an S corporation, there are still ways to avoid paying the transition tax in which they will be able to potentially maintain their deferral status indefinitely as long as no “triggering event” occurs.
4 Triggering Events to Avoid During Tax Deferral
- The S corporation ceases to be an S corporation.
- There’s a liquidation or sale of substantially all of the S corporation’s assets.
- The S corporation goes out of existence.
- There’s a transfer of any of the S corporation’s shares by sale, reason of the shareholder’s death, or otherwise.
Even after the triggering event occurs the shareholder will still have the option to pay the transition tax over an 8 year period, beginning in the year of the triggering event. The election to defer transition tax is made on a shareholder-by-shareholder basis but once a shareholder elects to defer then the S corporation becomes jointly and severally liable for that shareholders transition tax.
All shareholders should be in agreement when electing to defer to avoid putting the S corporate at risk for payment of the transition tax. Paying the transition tax now could be more beneficial than deferring because of the tax breaks included in the NOW one-time repatriation fee. This would be the way to go if the foreign corporation is at least 10$% owned by a US domestic corporation.
Foreign corporations will receive big tax breaks with the newly introduced dividends received deduction (DRD). DRD will allow for 100 percent deduction for foreign income earned. Corporations with foreign subsidiaries will need to first claim all deferred foreign earnings that have not yet been taxed before taking advantage of the DRD. This prevents these previous assets of falling into permanent exclusion.
The good news is the previously deferred income will be taxed at the new rates of 15.5% for cash assets and 8% for illiquid assets instead of the firm 35% before the tax reform. In addition to that reduction these multinational corporations will also get a foreign tax credit equal to the proportion of their tax rate deduction. Cash assets will receive a 56% tax credit (35% to 15.5%) and the illiquid assets will receive a 78% tax credit (35% to 8%).
The trick is for overseas operations to reduce their cash positions. Using the above loophole multinational corporations can reduce their repatriate tax to almost nothing by using dividend payments and other legitimate ways of distributing money.
Planning to Maintain Deferral or Limit Transition Tax
Without proper planning the transition taxes can cause serious tax consequences to a company’s tax liability. Company accountants or other decision making executives charged with cash management may not even be aware of all the tax rules pertaining to the new tax reform. Having repatriation agreements in loan documents, cash flow sweeps, limits on excess foreign cash and similar provisions may incentivize cash management policies that could no longer be relevant with the new tax laws.
Strategically managing cash balances, credit agreement covenants, intercompany debt balances and transition issues with foreign operations is challenging. With proper planning, foreign companies can still meet their tax deferral objectives while lenders get the security they want and the negative changes to taxes on foreign corporation can be minimized or eliminated. Companies need to seek consultation from a CPA with significant international tax experience to see what is the best way of moving forward with their foreign corporation since the introduction of the tax reform.